Capital Structure Theory – Net Income Approach

Net Income Approach suggests that value of the firm can be increased by decreasing the overall cost of capital (WACC) through higher debt proportion. There are various theories which propagate the ‘ideal’ capital mix / capital structure for a firm. Capital structure is the proportion of debt and equity in which a corporate finances its business. The capital structure of a company/firm plays a very important role in determining the value of a firm.

Introduction to Capital Structure Theory

A corporate can finance its business mainly by 2 means i.e. debts and equity. However, the proportion of each of these could vary from business to business. A company can choose to have a structure which has 50% each of debt and equity or more of one and less of another. Capital structure is also referred to as financial leverage, which strictly means the proportion of debt or borrowed funds in the financing mix of a company.

Net Income ApproachDebt structuring can be a handy option because the interest payable on debts is tax deductible (deductible from net profit before tax). Hence, debt is a cheaper source of finance. But increasing debt has its own share of drawbacks like increased risk of bankruptcy, increased fixed interest obligations etc.

For finding the optimum capital structure in order to maximize shareholder’s wealth or value of the firm, different theories (approaches) have evolved. Let us now look at the first approach

Net Income Approach Explained

Net Income Approach was presented by Durand. The theory suggests increasing value of the firm by decreasing the overall cost of capital which is measured in terms of Weighted Average Cost of Capital. This can be done by having a higher proportion of debt, which is a cheaper source of finance compared to equity finance.

Weighted Average Cost of Capital (WACC) is the weighted average costs of equity and debts where the weights are the amount of capital raised from each source.



Required Rate of Return x Amount of Equity + Rate of Interest x Amount of Debt

Total Amount of Capital (Debt + Equity)

According to Net Income Approach, change in the financial leverage of a firm will lead to a corresponding change in the Weighted Average Cost of Capital (WACC) and also the value of the company. The Net Income Approach suggests that with the increase in leverage (proportion of debt), the WACC decreases and the value of firm increases. On the other hand, if there is a decrease in the leverage, the WACC increases and thereby the value of the firm decreases.

For example, vis-à-vis equity-debt mix of 50:50, if the equity-debt mix changes to 20: 80, it would have a positive impact on the value of the business and thereby increase the value per share.

Assumptions of Net Income Approach

Net Income Approach makes certain assumptions which are as follows.

  • The increase in debt will not affect the confidence levels of the investors.
  • The cost of debt is less than the cost of equity.
  • There are no taxes levied.


Consider a fictitious company with below figures. All figures in USD.

Earnings before Interest Tax (EBIT) = 100,000
Bonds (Debt part) = 300,000
Cost of Bonds issued (Debt) = 10%
Cost of Equity = 14%

 Calculating the value of a company

EBIT = 100,000
Less: Interest cost (10% of 300,000) = 30,000
Earnings after Interest Tax (since tax is assumed to be absent) = 70,000
Shareholders’ Earnings = 70,000
Market value of Equity (70,000/14%) = 500,000
Market value of Debt = 300,000
Total Market value = 800,000
Overall cost of capital = EBIT/(Total value of firm)
= 100,000/800,000
= 12.5%

Now, assume that the proportion of debt increases from 300,000 to 400,000 and everything else remains same.




Less: Interest cost (10% of 300,000)



Earnings after Interest Tax (since tax is assumed to be absent)



Shareholders’ Earnings



Market value of Equity (60,000/14%)


428,570 (approx)

Market value of Debt



Total Market value



Overall cost of capital


EBIT/(Total value of firm)




12% (approx)

As observed, in case of Net Income Approach, with increase in debt proportion, the total market value of the company increases and cost of capital decreases.

Last updated on : August 31st, 2017
What’s your view on this? Share it in comments below.


  1. Ashwani sinfg
  2. Kunal ganesh
  3. wilson
  4. varsha

Leave a Reply

Capital Structure Theory – Net Operating Income …
  • Financial Leverage
    Financial Leverage
  • Traditional Approach
    Capital Structure Theory – Traditional Approach
  • Operating Leverage and Degree of Operating Leverage
    Operating Leverage
  • Modigliani and Miller (MM) Approach
    Capital Structure Theory – Modigliani and Miller …
  • Subscribe to Blog via Email

    Enter your email address to subscribe to this blog and receive notifications of new posts by email.

    Join 122 other subscribers

    Recent Posts

    Find us on Facebook

    Related pages

    semi variable costs definitionbank overdraftsassociated bank overdraftadvantages of double entry bookkeeping systemwhat is meant by waccis the budgeting exercise of any usepayback period calculation examplesinstallment sales agreementletter of hypothecation sampleeva waccadvantages of mergers and acquisitionsdegree of operating leverage definitionpayback period definitiondefinition of debits and credits in accountingmodified internal rate of returnpreference shares vs equity sharesexamples of fixed expenses and variable expensesdscr excelfuture value formula compounded annuallydebtors ratiohow to calculate days receivable ratiobudgeting in managerial accountingwhat is the difference between an acquisition and a mergerexample of decoupling inventoryformula of dividend payout ratiomeaning of debit and credit in accountingbenchmark debtor financehow do you calculate average inventorydefinition of a debenturedividend discount model formularevolving letter of credit examplewhat are bonds and debenturesadvantages and disadvantages of cash flowregister of debenturesfinancial leverage ratio interpretationinternational capital budgeting techniquesadvantages and disadvantages of break evenfixed capital investment definitionaverage inventory turnover formulainternal rate of return formulameaning of higher purchaseasset revaluationdebits and credits for dummiesadvantages and disadvantages of debt financinglimitations of abc analysisebit calculation examplecash turnover ratio formulabills of exchange definition wikipediadefinition of owners equitymirr financial calculatordifference between credit and debit in accountingwhat is tod in banking termsnpv disadvantagesdebentures payableresidential leaseback agreementdefinition of costing and cost accountinggaap book valuecapital lease journal entries lessorfinancial leverage ratio interpretationoperating lease journal entrieshow calculate irraccounts receivable turnover ratio calculatormarket to book ratio calculatorsales turnover ratio definitionmarginal costing for decision makingreceivable turnover analysishow to calculate break even sales in unitsebitda equationinternational trade disadvantagesimportance of leverage in financial managementaccounting capitalization rulesinventory turnover period formulapv of a dollarirr interpolation formuladefine zero coupon bondrbi ecb guidelinesdefine bank overdraftnopat calculationhow to calculate the average collection periodtotal inventoriable product costhypothecationsdefinition of irredeemableshareholder vs stockholder